Typically, the lead into the holiday liquidity drain presents a mild boost to risk-sensitive assets as volatility tapers off. And, naturally, the safe haven dollar suffers for the market tranquilizer. Yet, that wasn’t the scenario we were met with this past week. Though the last full week of trading before the holiday’s take a large swath of the western world offline through the remainder of the year, we saw a clear increase in speculative uncertainty and particularly strong risk aversion shift through this past Friday’s session. The afterhours shock US equity futures felt after the House of Representatives failed to pass the Speaker’s ‘Plan B’ bill rippled over to the FX market as the London and New York sessions came online. For the Dow Jones FXCM Dollar Index (ticker = USDollar), a 0.4 percent advance represented the biggest rally advance since November 2 and cleared the pressure from serious congestion – with a bearish bias – that had developed over the past month.

What is particularly odd about the dollar’s performance to end the week was that the equities risk reaction preceded that of the dollar. Normally, it is the currency market that moves first, or they will move simultaneously. This delay suggests that it wasn’t just a late reaction to the bombastic Fiscal Cliff headline, rather we were also seeing the speculative unwind that normally precedes the liquidity drain ahead of holidays.

Looking ahead to the rest of 2012, shallow market depth and lingering fundamental uncertainties will create a volatile backdrop that curbs meaningful trends. On the other hand, there is still pent up risk in pairs like EURUSD and yen crosses; while the Fiscal Cliff remains an active catalyst. Given the S&P 500 and EURUSD have only retraced around1 percent from highs following 7.7 and 5.1 percent rallies (respectively) from mid-November, there is likely a considerable level of exposure that can be unwound naturally or with the encouragement of uncertainty in the US fiscal health. Following the timeline for the Congress-White House negotiations, the House of Representatives (a critical leg to the proceedings) isn’t scheduled to reconvene until the afternoon December 27. That leaves only two full business days to strike a deal before the turn of the year and the automatic tax hikes and spending cuts take effect. Even if it is still more likely that a resolution is found, the last minute antics will act to unnerve speculators that are attempting to remain in the market.

Japanese Yen Still Heavily Oversold and Risk Sensitive

The Japanese may have gained ground against all of its major counterparts this past Friday (from 0.2 percent against the dollar to 1.5 percent versus its New Zealand currency), but this barely a minor percentage of the currency’s massive depreciation over the past weeks and months. Over the past month, the yen has plunged between 5.0 and 8.7 percent while over the past five months it has collapsed between 7.8 and 16.9 percent. Over the long-term, the funding currency is absolutely overbought and likely to systemic declines at the hands of a stimulus-minded, LDP-led government. Yet, there is a threat of risk aversion (which kills carry exposure) and the overbought bearing of the currency exposes it even in calm conditions. For the yen crosses to continue their incredible climb (yen depreciates), we would need a strong risk appetite advance or definable progress on Japanese stimulus efforts. Both are low probability and thereby not my primary bias.

Euro Risks More Prominent than Advance Lets OnAfter the kiwi dollar’s retracement this past week, the euro easily takes the spot as the market’s most overbought currency. Over the past two weeks, over the past two weeks alone, it has advanced between 1.2 and 4.0 percent against its major counterparts (with the exception of EURCHF). This most recent leg of strength has come on the back of the long-awaited progress on the Greek rescue payment – first the bond buyback program and then officially receiving its tranche of aid. This certainly removes an imminent risk from the immediate path of the euro, but how much of this outcome was already priced in? How long can a rally based purely on ‘relief’ last? That likely depends on underlying risk trends over the next week. And, beyond that, we will return to Spain’s financial troubles, Italy’s election and Portugal’s demands for equal treatment.

British Pound Finally Breaks Exhausted Drive with Biggest Dive in Four Months

Considering GBPUSD and GBPJPY extended their impressive advances to top 15 and 20-month highs respectively, there were certainly an air of extreme positioning for both. A general buoyancy through risk trends no doubt contributed to this move, but that lift has stabilized. What’s left is a sterling that has few selling points of its own for distinct fundamental strength. The cable’s impressive 0.7 percent (107 pip) drop Friday was the biggest in four months and is a good representation of what over-extended markets are prone to do in thin conditions.

New Zealand Relieves Overbought Leverage Better Than Counterparts

There was certainly a risk aversion shift late this past week, but little pressure was relieved from most extreme assets. The exception, however, was the New Zealand dollar. Over the past week, the kiwi has tumbled between 1.2 and 3 percent to significantly ease the sensation of extreme positioning. What does this mean for the week ahead? If there isn’t an active risk deleveraging move in market, the kiwi won’t naturally ease.

Canadian Dollar: Steady GDP and Easing CPI Good for Economy, Not Yields

While most traders were focusing on the general bearing and pace of risk trends Friday in the wake of the Fiscal Cliff headlines, the Canadian dollar had more than its fair share of tangible fundamental leverage. October GDP figures offered a tepid pace of growth to add to its elite status while a three-year low from the headline CPI takes a dangerous jab at its unique, hawkish interest rate outlook.

Gold Posts Biggest Weekly Drop in Six Months Despite Uncertainties

Gold has dropped 2.3 percent – the biggest tumble for the metal since the period ending June 22. This aggressive slide is remarkable for its momentum against a rather steady dollar (its primary foil), the push below the 200-day moving average and the distance it has claimed since rejecting $1800. It seems few investors want to hold a potentially volatile and illiquid commodity if a Fiscal Cliff deal is done.